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Crowning the Kings (Rule Maker Portfolio) January 22, 1999

Austin, TX (Jan. 22, 1999) -- Today's article is a bit longer than usual, since I'm covering each of our companies in detail. You might want to grab a soda (may I suggest a Coke?), and remember: you have the whole weekend to read it.

Yesterday I said I'd talk about companies in our portfolio that qualify as both Cash-Kings and Merchant-Kings. I said I could think of at least two at the time. Let's find them by eliminating the pure Cash-Kings from our portfolio that do not really have Merchant-King aspects. Remember: Merchant-Kings are low cost, low inventory, streamlined, efficient businesses with ultra-short cash conversion cycles and easily expandable businesses, usually concentrating on distribution.

Our financial companies are basically in the services business. T. Rowe Price(NYSE: TROW) will manage your money for a fee, and American Express(NYSE: AXP) will do all sorts of things involving money for a fee. I personally found it difficult to evaluate them from a Cash-King perspective since their businesses and balance sheets are virtually a foreign language from the make-and-sell-things businesses in the rest of our portfolio, and properly evaluating them as Merchant-Kings is also beyond me. Low inventory? But their inventory is cash, they want to hang on to it! How does that translate?

I mostly consider our financial pair "out of my circle of competence" and leave them to Al and Phil, who do this sort of thing for a living. But one thing is clear to me: neither of the two is fighting to be the cheapest or fastest way to do what they do. For example, online brokerages like Datek seriously undercut full service brokers like T. Rowe on stock trading commissions, and Visa and MasterCard both charge lower fees (to retailers) than the American Express card. These companies instead concentrate on being the best at what they do: high-end, high-margin Cash-Kings. Let's leave them to it and move on.

Pfizer(NYSE: PFE) and Schering-Plough(NYSE: SGP) are both pharmaceutical companies. They're subject to a lot of government regulation and require intensive development efforts that take a lot of money and a very long time to produce and secure approval for new products. In addition, highly trained, talented, and experienced biochemists don't exactly grow on trees, and you can't put some other employee through a three week in-house course to bring them up to speed on the subject. This requires a lengthy and expensive university degree, plus innate talent.

Now, this isn't entirely a bad thing for their investors, as the high front-end costs provide part of the "moat" around their business that discourages competition and raises its profit margins. The patent protection on new drugs is a great balance sheet booster as well. But the nature of the process does prevent their product line from scaling up cheaply. From a manufacturing standpoint they're better off, although some drugs are fragile things requiring dark bottles to be kept in refrigerators and discarded after a few weeks. But it's really the distribution that disqualifies them: most of their more profitable products require prescriptions to be sold, depriving them of control of exactly how and when they sell to customers. Possibly a case could be made that over the counter medications like Tylenol could be Merchant-King material, but that's a different story.

Intel(Nasdaq: INTC) is in a situation similar to the pharmaceutical companies. The up front costs of a new microchip line are enormous. The design requires highly trained (rare, expensive) experts and can take years, and the costs of a new manufacturing facility (research and construction) are staggering. Intel can literally spend billions of dollars to launch a new chip. Again, that's not a bad way to run a Cash-King. Competition is kept to a minimum by the staggering price of the admission ticket into the arena.

Admittedly Intel does a pretty good job on the Merchant-King parts of its business. Microchips decline in price so fast Intel had better get them out the door even faster. And like the pharmaceuticals' tiny little pill bottles, microchips are small high-value items easy to store and transport. Since Intel can sell directly to anybody it wants to, it's also better off than the pharmaceuticals.

In Intel's case, I wouldn't currently call it a Merchant-King because its competition clearly disqualifies it. The cheapest way to power your computer is using a chip from a competitor like Advanced Micro Devices(Nasdaq: AMD). Intel benefits from lower costs, but has not yet chosen to flex its price muscles to gain market share from its competition. This is probably wise on its part: don't look like a monopoly while the antitrust sharks are circling around a nearby target.

So Intel has some Merchant-King strengths, but it's not utilizing them. Intel has AMD on a leash made of higher gross margins resulting from Intel's lower manufacturing and distribution costs and the sheer economy of scale of the larger business. AMD is losing money by undercutting Intel anyway (to gain market share), and Intel could put AMD out of business at any time with sharp price cuts. But Intel is purposely keeping that leash long these days. It's a coin toss, but it comes down "no." (Flexing muscles, longer leash, and a coin toss that comes down "no." Not just a mixed metaphor, that one was set on "puree.")

Cisco(Nasdaq: CSCO) and Gap Inc.(NYSE: GPS) are in better Merchant-King positions, with Cisco selling into an explosively expanding market and Gap selling a cheaply manufactured product (textiles) that gives more opportunity for its distribution and inventory management to impact its bottom line. But neither particularly springs to mind as "competing on price" with their competition, and I have to penalize them for the simple fact that they manufacture their own products (as opposed to pure Merchant-Kings like Wal-Mart, Home Depot, Amazon, or Southwest Airlines). Again the coin comes down "no."

There are only two companies left, and I said we had two Merchant-Kings hiding in our portfolio. Our existing Rule-Makers were primarily chosen on pure Cash-King criteria, but two of them also deserve a second, Merchant-King crown: Coca-Cola(NYSE: KO) and, to be honest, Microsoft(NYSE: MSFT).

The Coca-Cola Co. manufactures Coca-Cola syrup. This isn't colored, flavored, fizzy, sugar water, this is dehydrated syrup that can make gallons of colored flavored fizzy sugar water when a bottler (or soda fountain) adds the fizzy water. It's basically a mix of spices and corn syrup, and it is DIRT CHEAP to make. The penalty for being a manufacturer is really low here. Add to that a distribution network that brings Coke daily to the mountains of Tibet, the jungles of Peru, and your local grocery store. Plus these guys invented the vending machine to sell their product without needing people to take the money. As for competing on price, maybe not with Pepsi, but with other drinks like milk, tea, wine, or orange juice, sure. Coca-Cola has had a century to perfect every aspect of its business model, and its done a wonderful job. It's a Cash-King and a Merchant-King, all in one.

The case for Microsoft admittedly seems a touch weaker than Coke's at first because of its up-front costs of software development. Although Microsoft protests loudly that two guys in a garage can write an operating system that can displace it, Softy itself takes years and spends many millions doing so. That said, Microsoft's ability to sell the products once they're developed is astounding.

First of all, Microsoft doesn't actually sell software. It licenses it. What you buy from Microsoft isn't a copy of Windows; you could make your own copy easily. What you get is the legal right to use Windows, a license for it without which any copy you make would be illegal. This is not a normal retail concept. Most people think they actually are buying the software and don't bother to read the small print, but this is how a freely and infinitely copyable product can turn into a revenue generator -- by making a legal service out of it.

So inventory of Microsoft's real product, software licenses, is nonexistent. It's granted with a magic wand. Inventory for supporting products (CD-ROMs with actual copies of the software, documentation, little legal contracts under the shrinkwrap) exists, but it's dirt cheap to make and store, and in fact disposable with the advent of the Internet and the ability to download software after supplying a credit card number and clicking on the "yes I agree with the license" button. A Web browser can become a software vending machine, beating out even Coke since you don't have to send someone around to refill it.

Microsoft also has a stranglehold on resellers. Put bluntly, Compaq smiles when Microsoft tells it to, as evidenced by its schizophrenic behavior in the antitrust trial. These days, it's almost impossible to buy a finished computer from a major manufacturer that does NOT come with windows. Consumer advocate Ralph Nader tried. From a distribution standpoint, it's not a matter of being "better" -- better than who? At the moment, Microsoft is virtually unrivaled, although there are some signs of that changing.

While I have nuclear qualms about the rest of Microsoft's business (I don't like its business tactics, question its ability to actually compete without a stacked deck, think the "we can bundle a ham sandwich if we want to" quote was a bad way to start the antitrust trial, wouldn't exactly call it innovative... I'll stop now...), I must admit the company's distribution and inventory management are supernaturally strong. Maybe using exclusive distribution contracts to starve out competitors isn't the most ethical (or legal) way to use a Merchant-King's strength, but there's no question that it does have that strength. In spades.

I must reluctantly hand over a second Merchant-King crown, to Microsoft.